Making The Shift From Employee To Business Owner

A Look At Compensation, Health Insurance and Imputed Income

When you make the shift from being an employee to a business owner, you’ll want to gain an understanding of how compensation and health insurance will differ as a business owner versus that of an employee, as well as familiarize yourself with something called imputed income. Compensation, health insurance and imputed income will vary depending on the type of legal business entity you form (ex: single-member LLC, LLC taxed as a Partnership, LLC taxed as a S-Corp, S-Corp, C-Corp).

Let’s look at a few examples …

Compensation

When you become a business owner, how you receive compensation will vary depending on the type of business entity you have formed. Unlike an employee, you will not necessarily be paid through payroll nor will you receive a Form W-2 at year end.

For example, if you are a member of a LLC taxed as a Partnership, you will receive Guaranteed Payments in lieu of a salary through payroll. Unlike an employee who receives payroll wages which are subject to withholdings for federal, state and local income taxes as well as a 50/50 split between the employee and employer for Medicare and Social Security (aka FICA), which are reported and remitted quarterly by the employer (or their payroll company), you will be responsible for reporting and remitting any applicable federal, state and local quarterly estimated tax payments inclusive of self-employment taxes (100% of Medicare & Social Security) as well as income taxes on those Guaranteed Payments. A member of a LLC may also receive distributions of profit. Keep in mind that LLC members must pay taxes on their respective share of profits from business income as reflected on their Schedule K-1.

As another example, if you are a shareholder-employee of a LLC taxed as a S-Corp or a shareholder-employee of a S-Corp, the IRS requires that you receive a reasonable salary with those wages subject to normal payroll tax withholdings. Shareholders may also receive distributions. Shareholders will receive a Form W-2 for their payroll wages at year end. Shareholders are also subject to taxes on their respective share of profits from business income as reflected on their Schedule K-1 and should report and remit any federal, state and local quarterly estimated tax payments, if applicable.

Health Insurance

As a business owner, you may be able to participate in the company’s group health insurance plan if one exists; however, your participation may be permitted only on a post-tax basis whereas employees may usually participate on a pre-tax basis.

For instance, a member of a LLC taxed as a Partnership, a shareholder with greater than 2% ownership of a LLC taxed as a S-Corp and a 2% S-Corp shareholder (S-Corp shareholder with greater than 2% ownership and/or voting rights) may participate in the company’s group health insurance plan on a post-tax basis. If you’ve previously relied on the pre-tax benefit to help reduce your taxable income, you’ll want to consult with a CPA to determine how the post-tax basis might impact your tax situation.

Imputed Income

If you are a business owner, you need to familiarize yourself with something called imputed income.

Imputed income is the value of any benefit or other non-monetary compensation offered to an employee by an employer which is taxable.

In many companies, employers will split the cost of the company’s group insurance plan premiums with their employees. For instance, the monthly health insurance premium for the company’s health plan is $1,000. The employer and employee split the cost of the premium 70/30; respectively. The employer contributes $700 towards the monthly premium and the employee contributes $300 towards the monthly premium.

The IRS treats the employer-paid portion of the monthly health insurance premium as a tax-free benefit for ordinary employees. However, for a shareholder-employee with greater than 2% ownership of a LLC taxed as a S-Corp or a 2% S-Corp shareholder (S-Corp shareholder with greater than 2% ownership and/or voting rights), the value of the employer-paid portion of the premium is considered imputed income. That is, the $700 portion of the premium paid by the employer will be treated as taxable income to the business owner and should be included on the shareholder-employee’s Form W-2.

Likewise, if the company pays 100% of the monthly health insurance premium for a shareholder-employee with greater than 2% ownership of a LLC taxed as a S-Corp or a 2% S-Corp shareholder, the entire employer-paid premium will be considered imputed income and taxable to the business owner.

These are just a few examples of how compensation and health insurance between a business owner and employee differ and how imputed income comes into play. Before you start a business, it’s important that you consult with a CPA, to discuss not only the type of business entity that would work best for you and your business but also discuss how each business entity may affect you as it pertains to areas including your compensation, health insurance and potential imputed income. You don’t want or need any surprises down the road!